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An Algorithm for the Pricing and Timing of the Option to make a Two-Stage Investment with Credit Guarantees

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  • Linjia Dong

    (Harbin Institute of Technology
    Southern University of Science and Technology)

  • Zhaojun Yang

    (Southern University of Science and Technology)

Abstract

We develop a jump-diffusion model for a guarantee-investment combination financing mode (G-I mode) that is recently popular in financial practice. We assume that a borrower has exclusively an option to invest in a project in two stages. The project’s cash flow follows a double exponential jump-diffusion process and it is increased by a growth factor once the second-stage investment is exercised. The first-stage investment cost is financed by a bank loan with the guarantee provided by an insurer, who promises to provide the second-stage investment cost as well as take the lender’s all default losses. In return for the guarantee and investment, the borrower pays a guarantee fee upon first investment and grants a fraction of equity upon second investment to the insurer. In sharp contrast to prior papers on guarantee, the guarantee costs are contracted prior to investment. We provide closed-form solutions and produce a numerical algorithm for the timing and pricing of the two investment options.

Suggested Citation

  • Linjia Dong & Zhaojun Yang, 2022. "An Algorithm for the Pricing and Timing of the Option to make a Two-Stage Investment with Credit Guarantees," Computational Economics, Springer;Society for Computational Economics, vol. 60(3), pages 1175-1196, October.
    • Handle: RePEc:kap:compec:v:60:y:2022:i:3:d:10.1007_s10614-021-10220-8
    DOI: 10.1007/s10614-021-10220-8
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    References listed on IDEAS

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